Ford: Why Many Are Looking At The Wrong Numbers

Summary:

• Ford’s earnings are complicated by Rivian’s impact and EVs, but the real issues are interest rate hikes and warranty costs.
• Ford’s significant EV losses are greatly overstated, due to a highly aggressive depreciation method and an EV mandate compliance credits valuation of $0 in internal transactions.
• Ford Credit’s earnings have plunged due to higher interest rates, this is the real hit to the company’s overall profitability.
• Warranty and interest rate hikes actually account for all the decline in Ford’s profitability since 2021.
• I continue to avoid Ford stock due to these underlying operational challenges and financial complexities.

As Ford (NYSE:F) prepares to report earnings today, I find myself writing about it for the first time since before the pandemic. A lot of articles I write could be considered Ford-adjacent, in a way, but this is the first time the company has been the proper focus of one of my articles in years.

Like everyone, I’ve been hearing a lot about Ford’s EV (Electric Vehicle) issues and warranty issues, and I frequently encounter people who assume those issues are one and the same, i.e., building EVs is spiking warranty costs.

I wanted to get to the bottom of what is really happening at Ford to cause the underperformance, since frankly, a lot of the important stuff is hidden in the earnings reports. What I’ve found is a little different than the prevailing narrative, although EVs and warranties certainly are issues of note.

Author Rating History On Ford

I put Ford in the rearview mirror a long time ago, and while things haven’t exactly gone the way I expected in the automotive sector, my judgement that Ford was not a good place to put my dollars has been more than vindicated. One could say that it’s better to be lucky than good, but I prefer to think that my assessment that the Detroit Three would underperform the newer innovators in automotive has shown through, even if the course of that innovation was not as expected.

Whether I’ve been lucky or good, I’m glad I stayed away. I argued in 2017 that it would be better to avoid all Detroit automotive stocks, but that General Motors (GM) would probably do less badly than Ford. Since then, that is exactly what has happened. Since my June 2017 call to avoid the autos, GM has lagged far, far behind the broader S&P market, with a return of just 73% as compared to a 141% return for the broader market. GM has yielded barely half the return of a typical stock in the past 7 years.

Ford stock, however, is actually down 1% over that same time frame. That’s right – you can buy a share of Ford stock for less money now than it would have cost you in 2017. This means that if two investors put their money into Ford and an index fund seven years ago, the Ford investor would have only forty cents for every dollar the index fund investor had today.

To be sure, the source of the trouble has been very different than what I expected. Back in 2017 I was a major fan of the growing prevalence of ride-hailing services like Uber (UBER) and Lyft (LYFT) and their ability to fundamentally revolutionize the mobility space. I still think they could do that if they wanted to, but it clearly isn’t their strategic direction right now. And the COVID-19 pandemic did severe damage to the “true ridesharing” businesses that I based my core thesis on – Lyft isn’t even in the sharing business anymore – and that isn’t likely to change anytime soon.

My thesis about ride-hailing didn’t pan out, or at least it hasn’t yet. Ford’s hits have come from other sources. The challenge is weeding those hits out of the general numbers.

Breaking Up With Rivian

One of the things that makes Ford’s financials a little harder to analyze is the company’s investment in Rivian (RIVN) a few years ago, which has played a bit of havoc with the GAAP accounting. Ford reported a $17.9 billion profit in 2021 and a $2 billion loss in 2022, before bouncing back to $4.3 billion in profit in 2023.

But those wild swings have a lot to do with Ford’s erstwhile EV partner. Ford reported a gain of $9.1 billion on its Rivian stake in 2021 before reporting a $7.4 billion loss in 2022. Strip the Rivian gyrations out, and Ford becomes profitable in all three years. That’s the good news. The bad news is that its “real” profit shows steady decline – $8.8 billion in 2021 through $5.4 billion in 2022 to last year’s figure.

Ford has been gradually disentangling itself from Rivian. Over the course of 2022 it sold roughly 90% of its holdings. That’s why it had minimal impact on Ford’s results in 2023. So in some ways, Ford’s 2023 reports are the first “clean” snapshot of the company’s earnings potential that we’ve had in a while.

Are EVs Really Such A Big Deal, Good Or Bad?

In a way, though, that just leads us back to Rivian again, or more accurately its product. The common practice has become to blame Ford’s profit decline on the EV “revolution” that’s starting to look a little fizzled out. And in a way, the numbers support that conclusion. Ford’s 2023 loss on EVs of $4.7 billion is almost exactly equal to the $4.5 billion “real” net income decline from the 2021 level. Clearly, competition with Tesla (TSLA) is expensive.

However, while I do not deny that EVs are not performing as well as they should be, I think it somewhat oversimplified to simply say “blame EVs” and assume that without them everything would be fine. In the first place, Ford’s EV loss was over 80% R&D related – only $700 million of it was non R&D.

So the common refrain about how Ford loses more money on every EV car than the consumer pays for it is superficial – a lot of that “loss” is front loaded from future sales.

In Deprecation Of Depreciation

In the automotive industry, a considerable portion of the total cost of a vehicle is R&D costs, which are being amortized over the life of the product line. Ford is paying upfront for R&D which it will continue to use over the 7- or 8-year lifespan of this generation of Electric Vehicles. True, its R&D spending won’t end there – like any going concern business, there’s always the next generation to consider.

But the way we account for these costs still matters. Right now, Ford’s earnings reports simply expense its R&D over the cars it sells the year the expense was incurred. That’s why Ford’s EVs look so massively unprofitable right now; a small number of EVs is bearing a whole generation’s worth of R&D costs.

But if you amortized that R&D spending using the income forecast method, i.e., spread it evenly over all the cars you expected to make using that R&D over the life of the vehicle generation, you’d get a much smaller current expense number. Because Ford’s whole reason for doing that EV R&D is that it expects to sell much more EVs in the future than it currently does. Ford would never spend what it is spending on electric R&D if 100,000 unit sales was the long-term plan.

It’s difficult to say, under that method, what the “real” profit/loss would be. Of course, if EV sales don’t pick up, it won’t make much difference. But whether those sales increase or not will have as much to do with political decisions yet to be made as with current economic factors that we can see today. Regardless of what you think about the EV revolution, politically, economically or environmentally, it will be a few years before we know how it will play out.

Supplementing Or Supplanting? It Matters

We also don’t know for sure how Ford’s R&D spending overall is trending. If it is spending twice as much to research two completely different power trains for the same number of cars, that’s obviously a problem.

To the extent, however, that it is simply replacing combustion R&D with electric R&D – because it expects to phase out the former vehicles as EPA mandates tighten – its R&D spending losses are largely a mirage, since it is cashing out its past R&D spending on ICE just as quickly as it is front-loading its EV spending.

I doubt all ICE spending at Ford has ceased, but we don’t know how, if at all, it has been reduced or otherwise affected.

The Strange Accounting Of EVs

What’s more, even the $700 million proper that Ford lost on the vehicles themselves last year may be somewhat misattributed. Growing regulatory burdens require that Ford and all automakers sell an increasing percentage of their vehicles as electric vehicles. Those who fail to hit these targets must pay to acquire credits from manufacturers who have exceeded the required allotment. In 2023 Ford reported agreeing to buy $700 million in EV compliance credits from third-parties in the fourth quarter alone, equal to the entire non-R&D operating loss for the whole year.

Granted, Ford discloses these deals at the time of signing, not as money is paid; Ford reported another $3.8 billion in credit purchases in Q2 2024, but only about $100 million of that was amortized that same quarter. Nevertheless, it is clear that building EVs generates compliance credits that have value.

Here is the key accounting point, though; the company’s financial treatment of these credits is a little uneven. When Ford buys credits from third-parties, it allocates those expenses to the vehicles they are attached to in the relevant vehicle sales segment. Ford now has three, Blue, Pro, and Model e. Pro and Model e both include EVs, for commercial and retail customers respectively, but Blue is strictly ICE for retail. Blue does include hybrid vehicles, but nothing that lacks a combustion engine.

When, however, Ford satisfies a compliance obligation internally by selling a Model e vehicle, it does not account for any of the compliance benefits. Essentially, it transfers compliance credits from Model e to the Blue segment – Pro I assume can look after itself – at an internal price of $0.

Transparency In All Its Glory And Chaos

In a way, this accounting is useful because it allows investors to see how far Ford is from making the EV segment profitable on a standalone basis – if someday every car is going to be electric, then compliance credits will eventually have a price of $0 in the real world, not just Ford’s accounting, and this way of presenting results indicates how far from being ready for that day Ford is. So in one way, it’s commendably transparent.

In another way, however, it’s extremely confusing. We know that the compliance benefits Model e creates are substantial. On the Q4 earnings call last year, CEO Farley indicated that each Lightning EV Ford sells gives it enough compliance credits to sell a dozen ICE ones. But with no internal pricing and no disclosure, we can’t see how much that benefit, which is being created entirely at Model e’s cost for Ford Blue’s benefit, is.

The paradox of this method is that the more EVs Ford produces, the more profitable its combustion division becomes, as expensive compliance credits are replaced with free ones.

Interest Rate Differentials Make Big Difference

On the other end of the scale is a division that is not being talked about as much, or at least not that I can see, but which has seen a swing almost as large as the EV segment in the past few years. Ford Credit is the company’s in-house financing arm. But the funny thing about captive auto finance is that it is as much a marketing loss-leader as a true business. We all know that; if you look at the advertisements on the TV you will find Ford frequently advertising “0% financing” just as it was in 2021 – despite the fact that the Fed Funds rate is 475 basis points higher now than it was three years ago. So the money they’re using to offer that financing has gotten a lot more expensive.

This means that Ford Credit EBT has predictably taken a plunge – from $4.7 billion in 2021, it was down to $1.3 billion in 2023.

Once again, the accounting is somewhat confusing here; Ford is reporting losses in its credit department that is more properly allocable to its vehicles. That financing offer is just part and parcel of doing business in the automotive sector. Ford could just cut the price of its vehicles proper and outsource all lending at the true rate of interest, but it prefers, like many car manufacturers, to offer 0% and bake the interest cost into the selling price of the car. Again, this makes Ford Blue look good at another division’s expense.

But once again, there is a sort of commendable transparency in this accounting approach; it means that we can see how much the Fed interest rate hikes have hit pricing of automobiles, and thus Ford’s earnings.

And that $3.4 billion differential isn’t much different from the decline in Ford’s Rivian-free net income either; it would account, on its own, for over three-quarters of it. After you factor in taxes, it would account for almost all of it.

Warranty Losses

To the extent that Ford’s losses need further accounting for – though it isn’t entirely clear they need any – one can certainly bring the warranty issue into it. Media coverage commonly portrays Ford’s warranty issues as costing the company $4.8 billion in 2023, a $600 million jump over 2022. In fact, the damage was much, much worse than that, but Ford’s warranty accounting treatment is also rather complex and could merit almost a whole article unto itself. Taking that too low number as given for the moment, then, it more than accounts for whatever profit decline since 2021 interest-rate hikes do not account for.

Nor is that all EV spending. While there are definitely EVs that have had repair costs above estimates – the announcement that Ford was suspending all F-150 Lightning EV sales to do quality checks on every EV in the inventory was particularly embarrassing – it’s clear that warranty costs are also accruing on non-EV vehicles. Witness the $270 million recall on vehicles with defective rearview cameras, for example. Even if some of those vehicles were EVs, I doubt very much being electric is why their cameras weren’t working.

Other Research Issues Of Note

I have done a deep dive on the ways investors can perhaps be led astray by the way the accountants go about counting some of these things, which means I had less room to talk about other factors. But those have been ably covered by other writers, so I will refer you to some of the excellent pieces other Seeking Alpha authors have put out in the past few days on Ford’s China competition, its extremely low P/E, and the prospects for improvement in its EV operations proper, as opposed to its compliance credit generation.

Moving The Debate Forward

More than even a buy or sell recommendation, though, I just want to sort of take the Ford conversation out of the somewhat politicized “EVs good/bad” muck it sometimes seems to be stuck in. Frankly, EVs don’t even appear to be the main source of Ford’s financial or warranty issues, and it amazes me how much more often I read about Ford’s EV troubles than its interest rate troubles. EVs are not irrelevant to Ford’s future, but nor are they the whole story, good or bad. It isn’t even entirely clear that they are the main story.

I am not saying that readers should think one way or the other about politics, climate change, or EV mandates. My point is simply that these issues should not obscure the purely economic questions of how car companies, the second most interest-rate sensitive consumer category after housing, are going to cope with higher long-term rates going forward. Ford’s particular problem with selling defective cars and then having to pay to repair them also isn’t EV-focused, necessarily.

Implications For Other Industry Companies

This is a Ford article, but obviously, one could apply similar frameworks of analysis to other car companies as well. Tesla and Rivian don’t have to worry about double-loading R&D with combustion, but they certainly should be viewed, like all automakers, through the prism of long-term profitability without regulatory credit arbitrage. And any analysis of ICE car companies like GM or Toyota (TM) needs to take account of how they are accounting for EPA credits to properly understand how each side of the gasoline/electric divide is faring.

Investment Summary

Ford’s earnings are a bit of a mess to sort through right now because the Rivian gyrations make it a little more difficult to see through to the underlying factors affecting the business. Ford has certainly put a lot of money into EVs, but that is more properly understood as a hedge against the future than a current expense. The real source of Ford’s actual operating decline is the combination of interest rate hikes and warranty costs on previously sold vehicles. Like many, however, I am somewhat concerned that management has not yet managed to successfully adapt to either of those factors.

So, while my reasons for doing so are, as usual, somewhat different than the consensus, I continue to Avoid Ford stock.

---

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

---